05/08/2014 05:20 EDT | Updated 07/08/2014 05:59 EDT

This Economic Cycle's Oxymoron: More Growth, Less Cash

Cash has been plentiful in emerging markets. Between 2009-2012 as quantitative easing ramped up, there was a massive expansion in borrowing on global bond markets by emerging market (EM) sovereigns, banks and companies. As a result, EM economies are now closely integrated into global debt markets, and thus more affected by actions taken in Developed Markets (DMs), particularly the withdrawal of quantitative easing (QE).

One of the most direct impacts of the QE unwind is that capital is becoming more expensive and difficult to access for EM sovereign and corporate entities. As a result of the change in availability and pricing of capital, Moody's estimates that emerging economies could face a cumulative 2013-2016 GDP growth loss of roughly 3 per cent, double the impact expected in developed markets.

It is worth noting that reduced access to capital is not just a consequence of tighter liquidity but also related to economic and political factors internal to each country. Many countries are seeing a coincidence of economic slowdown, political instability and tighter global credit challenging, to say the least. As a result, tighter credit is being felt to different extents in different countries (the so-called 'market differentiation') as some EMs have been, and will continue to be, more impacted than others depending on the degree of external vulnerability and reliance on external financing. The most obvious impact will be a tightening of EM sovereign access to capital.

Data show that EM sovereigns' borrowing costs are on the up and up. The JPM EMBIG (EM Sovereign Index) has seen bond yields increase by 46 per cent from their low point over the past three years to end of February. In looking at individual countries, it is clear that these increases are not entirely related to QT, as internal risk dynamics have provoked massive jumps in certain cases; Venezuela sovereign bond yields have jumped 88 per cent, Ukraine 79 per cent and Nigeria 71 per cent.

Low interest rates and easy availability of USD also impacted the commercial space in EMs. Hard currency borrowing by emerging market corporates has grown significantly, from $164 billion in 2009 to $502 billion by end of 2013. This has been a boon for corporate growth and investment, but with the years of access to cheap and easy capital slowly coming to an end, what does it mean for business in the years ahead?

Firstly, the EM corporate sector might not be hit as hard as the sovereign space due to the quality and resilience of the EM corporate bond market, much of which is investment grade. The May 2013 tapering announcement did lead to a spread spike, with the Credit Suisse Emerging Market IDBS Index rising from 326 bps on May 15, 2013 to a 2013 high of 448 bps five weeks later. However, the yields have since declined and in fact, the average EM corporate spread has been lower than the average over the last four years (loosely considered the QE period) of 406 bp.

The risk is that as borrowing costs rise, EM corporates' positions and ratings would suffer. Between 2014-2018, approximately $430 billion in hard currency bonds will mature.

This situation could be much worse should local currencies continue depreciating. Foreign currency- denominated debt now accounts for roughly 40% of the total in emerging markets. Those companies that are generating revenues in local currencies that are worth 20-30% less than a year ago may struggle to repay external debt.

The bottom line? This cycle's oxymoron looks like a downside story. But there's an opportunity for those with ready cash -- like Canadian institutions -- to fill the void, and right-size the picture. Remember, it's growth that's the initial cause of the liquidity problem.